# 16.4: Review and Practice

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### Summary

We have surveyed the experience of the United States in light of the economic theories that prevailed or emerged during five decades. We have seen that events in the past century have had significant effects on the ways in which economists look at and interpret macroeconomic ideas.

Before the Great Depression, macroeconomic thought was dominated by the classical school. That body of theory stressed the economy’s ability to reach full employment equilibrium on its own. The severity and duration of the Depression caused many economists to rethink their acceptance of natural equilibrating forces in the economy.

John Maynard Keynes issued the most telling challenge. He argued that wage rigidities and other factors could prevent the economy from closing a recessionary gap on its own. Further, he showed that expansionary fiscal and monetary policies could be used to increase aggregate demand and move the economy to its potential output. Although these ideas did not immediately affect U.S. policy, the increases in aggregate demand brought by the onset of World War II did bring the economy to full employment. Many economists became convinced of the validity of Keynes’s analysis and his prescriptions for macroeconomic policy.

Keynesian economics dominated economic policy in the United States in the 1960s. Fiscal and monetary policies increased aggregate demand and produced what was then the longest expansion in U.S. history. But the economy pushed well beyond full employment in the latter part of the decade, and inflation increased. While Keynesians were dominant, monetarist economists argued that it was monetary policy that accounted for the expansion of the 1960s and that fiscal policy could not affect aggregate demand.

Efforts by the Nixon administration in 1969 and 1970 to cool the economy ran afoul of shifts in the short-run aggregate supply curve. The ensuing decade saw a series of shifts in aggregate supply that contributed to three more recessions by 1982. As economists studied these shifts, they developed further the basic notions we now express in the aggregate demand–aggregate supply model: that changes in aggregate demand and aggregate supply affect income and the price level; that changes in fiscal and monetary policy can affect aggregate demand; and that in the long run, the economy moves to its potential level of output.

The events of the 1980s and beyond raised serious challenges for the monetarist and new classical schools. New Keynesian economists formulated revisions in their theories, incorporating many of the ideas suggested by monetarist and new classical economists. The new, more powerful theory of macroeconomic events has won considerable support among economists today.

## Problems

1. “For many years, the hands-off fiscal policies advocated by the classical economists held sway with American government. When times were hard, the prevailing response was to tough it out, awaiting the ‘inevitable’ turnaround. The lessons of the Great Depression and a booming wartime economy have since taught us, however, that government intervention is sometimes necessary and desirable—and that to an extent, we can take charge of our own economic lives.” Evaluate the foregoing quotation based upon the discussion in this chapter. How would you classify the speaker in terms of a school of economic thought?
2. In his 1982 Economic Report of the President, Ronald Reagan said, “We simply cannot blame crop failures and oil price increases for our basic inflation problem. The continuous, underlying cause was poor government policy.” What policies might he have been referring to?
3. Many journalists blamed economic policies of the Reagan administration for the extremely high levels of unemployment in 1982 and 1983. Given the record of the rest of the decade, do you agree that President Reagan’s economic policies were a failure? Why or why not?
4. The day after the U.S. stock market crash of October 19, 1987, Federal Reserve Board Chairman Alan Greenspan issued the following statement: “The Federal Reserve, consistent with its responsibilities as the nation’s central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system.” Evaluate why the Fed chairman might have been prompted to make such a statement.
5. Compare the rationale of the Reagan administration for the 1981 tax reductions with the rationale behind the Kennedy–Johnson tax cut of 1964, the Bush tax cut of 2001, and the Bush tax cut of 2003.
6. If the economy is operating below its potential output, what kind of gap exists? What kinds of fiscal or monetary policies might you use to close this gap? Can you think of any objection to the use of such policies?
7. If the economy is operating above its potential output, what kind of gap exists? What kinds of fiscal or monetary policies might you use to close this gap? Can you think of any objection to the use of such policies?
8. In General Theory, Keynes wrote of the importance of ideas. The world, he said, is ruled by little else. How important do you think his ideas have been for economic policy today?
9. State whether each of the following events appears to be the result of a shift in short-run aggregate supply or aggregate demand, and state the direction of the shift involved.

1. The price level rises sharply while real GDP falls.
2. The price level and real GDP rise.
3. The price level falls while real GDP rises.
4. The price level and real GDP fall.
10. Explain whether each of the following events and policies will affect the aggregate demand curve or the short-run aggregate supply curve, and state what will happen to the price level and real GDP.

1. Oil prices rise
2. The Fed sells bonds
3. Government purchases increase
4. Federal taxes increase
5. The government slashes transfer payment spending
6. Oil prices fall
11. Using the model of aggregate demand and aggregate supply, illustrate an economy with a recessionary gap. Show how a policy of nonintervention would ultimately close the gap. Show the alternative of closing the gap through stabilization policy.
12. Using the model of aggregate demand and aggregate supply, illustrate an economy with an inflationary gap. Show how a policy of nonintervention would ultimately close the gap. Show the alternative of closing the gap through stabilization policy.

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